Concept Of The Cost Of Money
The cost of money refers to the price paid for using the money, whether borrowed or owned. Every sum of money used by corporations bears cost. The interest paid on debt capital and the dividends paid on ownership capital are examples of the cost of money. The supply of and demand for capital is the factor that affects the cost of money. In addition, the cost of money is affected by the following factors as below:
Factors Affecting The Cost Of Money
1. Production Opportunities
Production opportunities refer to the profitable opportunities for investment in productive assets. Increase in production opportunities in an economy increases the cost of money. Higher the production opportunities more will be the demand for money which leads to higher cost of money.
2. Time Preference For Consumption
Time preference for consumption refers to the preference of consumers for current consumption as opposed to future consumption. The cost of money also depends on whether the consumers prefer to consume in current period or in future period. If the consumers prefer to consume in current period, they spend larger portion of their earnings in current consumption. It leads to the lower saving. Lower saving reduces the supply of money causing the cost of money increase. Therefore, as much as the consumers give high preference to current consumption, the cost of money will increase and vice versa.
Risk refers to the chance of loss. In the context of financial markets, risk means the chance that investment would not produce promised return. The degree of risk perceived by investors and the cost of money has positive relationship. If an investor perceives high degree of risk from a given investment alternative, he or she will demand higher rate of return, and hence the cost of money will increase.
Inflation refers to the tendency of prices to increase over periods. The expected future rate of inflation also affects the cost of money, because, it affects the purchasing power of investors. Increasing in rate of inflation results in decline in purchasing power of investors. The investors will demand higher rate of return to commensurate against decline in purchasing power because of inflation.